Citigroup (C) reported quarterly earnings on Thursday that sent shares down over 3.5% (press release available here). Prior to this report, Citi stock had been performing well and was up 24.6% over the past twelve months, roughly in-line with the S&P 500's performance. After this quarter, many investors are now concerned that this run up may not have been justified and that Citi will not be able to return much capital to shareholders. After looking through the numbers, I am not as pessimistic and believe Citi shares offer a strong value proposition at current levels.
Adjusting for one-time items, Citi reported earnings of $0.82, which was up 19% year over year. Revenue was down to $17.8 billion from $18.66 billion last year. Citi was able to maintain profitability thanks to strong cost cutting effort with expenses down 13% year over year. Citi is now one of the leaner, more efficient bank, which should lead to rapid profit expansion as revenue growth returns. Analysts had been looking for $0.95 on $18.2 billion in revenue, so this quarter was a significant disappointment.
Before looking at some of the negatives in the report, it is important to note that the quarter wasn't all doom and gloom. Book value finished up 6% at $65.31, and Citi Holdings (the bad bank) was down 25% to $117 billion or 6% of total assets. Core loans were up a solid 7%, which should translate into earnings growth in 2015. The bank also remains extremely well capitalized with a Basel III Tier I Common Equity Ratio of 10.5%. Importantly, regulators are focused increasingly on leverage ratios as a way to determine whether a bank is safe. U.S. regulators seem to view 5% as a strong level, and Citi easily surpasses that level at 5.4%. On the capital front, Citi is in good shape. Now, let's look at what drove weaker results.
North American commercial banking declined 8% to $4.9 billion driven by weak refinancing activities and tight net interest margins of 2.88%. On the positive side, commercial loans were up 10% year over year. With a stronger economy and business confidence, commercial loan growth should be a key driver going forward. With higher interest rates, refinancing activity will remain weak in 2014, which will cut mortgage origination revenue. However in the long run, higher interest rates are a good thing for Citigroup.
Last year's refinancing pace wasn't maintainable as rates eventually had to rise. 2014 and 2015 should be strong years for net interest margins as long rates increase while short rates remain low. With a decent economy, loan demand (especially for autos and home purchases, not refinances) should be pretty strong over the next 2-3 years. This means Citi will be making loans at a higher rate, which will increase its average interest rate earned.
While interest earned will start to grow, interest expense will remain low because the Federal Reserve is will likely the overnight rate below 0.25% into mid-2015. The Fed funds rate is a major driver of deposit interest rates, which is a primary source of Citi's funding. As this rate will remain low, Citi will continue to have very low interest expense. Over the next two years, the curve will steepen as the Fed lets the long end of the curve rise while the short end stays near 0%. In this environment, net interest margins should climb, which is extremely accretive for Citi's earnings power.
Citi's international business offered mixed results, though in the long run, I think Citi should benefit from growth in Latin America, Asia, and the Middle East. While growth will be bumpy, Citi's banking revenues should roughly track economy activity, which should outpace the developed world over the next decade. In the quarter, headline revenue was down 1% to $4.6 billion. A stronger dollar was a major reason for this decline as revenue grew 2% on a constant dollar basis. I believe that the dollar will struggle over the next decade as inflation returns, which will make Citi's international exposure a major growth engine.
Latin American revenue grew 8% on a constant currency basis though Asia was down 3% due to some regulatory shifts that force more conservative lending. The company is repositioning a bit in South Korea in order to gain market share, which has elevated expenses in the short term but should translate to stronger revenue in the second half of 2014 and 2015. Of all U.S. based banks, Citigroup is really the only global consumer bank. As emerging markets continue to develop and form a middle class, demands for traditional banking services like deposits, credit cards, and mortgages will grow tremendously. While emerging market exposure was a challenge this quarter due to the dollar, it is a major opportunity over the next 5-10 years.
Last, Securities and Banking continues to be a challenge because the overall environment is still far from perfect. Investment banking and equities revenue were up 3% and 16% year over year at $1.036 billion and $539 million respectively. Fixed Income continues to be a major drag as revenues fell 15% to $2.329 billion. Rising rates have led to a mass exodus from the fixed income world, and trading volumes have been weak. 2014 is not going to be a strong year for fixed income though improving M&A and IPO activity will help IB and Equity revenues. With an aging population, there will still be demand for fixed income products over the next 5-10 years, and I don't believe this segment is in structural decline. Nonetheless, I expect total 2014 Securities and Banking revenue to be flat or mildly positive.
This quarter's weakness was driven by slower U.S. refinancing activities, a stronger dollar, and lower fixed income trading. In 2014, refinancing will remain weak though stronger commercial loans should power overall loan growth of 6-10%. Further, rising rates should be accretive to net interest margins. While emerging markets have some challenges that will hold back 2014 growth, they should power stronger growth over a decade. I also expect 2014 to be a bottoming year in fixed income revenue as an older population reallocates to this market in 2015 when rates are higher.
In 2014, I continue to look for Citi to earn $5.15-$5.35, which would suggest an improvement in the company's return on equity to 7.5-8%. At current prices, Citi is trading at 81% of book value and at 10x 2014 earnings. This valuation more than fully accounts for near term headwinds while discounting long term growth potential in emerging markets and strong interest margins. Now, management is forecasting a decline in NIM in 2014 to 2.85% from 2.88%, but I believe this is rooted in their conservatism and preference to beat expectations rather than report another weak quarter that disappoints the street. A steepening curve will boost margins over 2014-2016.
I do believe that Citi will start to return capital to shareholders in 2014 though I expect returns to lag those of competitors. I am looking for a quarterly dividend in the range of $0.10-$0.15 and a buyback of roughly of $5 billion. As shares trade at a 20% discount to book value, buying back shares will be very accretive to existing holders. As growth picks up in 2015, I expect far stronger capital returns. While this quarter was a bump in the road, the Citi bull thesis remains intact, and I expect shares to trade to trade up to book value in 2014 or $65. At current prices, I would buy Citi.